Private equity: What to consider before investing

Investing in private equity differs significantly from traditional asset classes. I'll take you through 4 things you need to be aware of and 5 decisions you have to make before investing in private equity.

Jan 08, 2024

Private equity

Ken Gamskjær

CEO and Founder

Buying public stocks in a company and investing in a private equity fund are two very different things.

Investments in public stocks are liquid investments, whereas private equity investments are illiquid and can't be sold from one minute to another.

The public market is highly regulated with stringent reporting rules for listed companies. On the other hand, the private markets have no standardized reporting practices and are therefore less transparent than the public market.

There are many reasons why the private equity universe is much more complex than the public stock market. Therefore, there are certain things that you need to be aware of before entering the jungle that private equity can be.

In this article, I'll take you through 4 things you need to be aware of and 5 decisions you have to make before investing in private equity.

Let's go!

Or wait, let's just take a quick recap of how private equity investment works in case you haven't read our article Private equity: What is it? (but of course, you have).

How private equity investment works

When investing in private equity, you commit to investing a specific amount in the private equity fund. Instead of paying that amount immediately, you make a capital commitment, known as a commitment in the private equity world.

This commitment is binding throughout the fund's lifespan and allows the fund to make capital calls when they need capital from their investors (you) for acquiring new companies or covering expenses. The portion of your commitment that you haven't fulfilled yet is referred to as your unfunded commitment.

Members of a private equity fund can be broadly divided into two parties – a General Partner (GP) and a group of Limited Partners (LP). The General Partner is the private equity company that establishes the private equity fund, raises capital from investors, and manages the fund, while the Limited Partners are the investors who commit capital to the fund.

Now, let's explore the considerations you should be aware of before investing in private equity.

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4 factors to consider when contemplating investing in private equity

1. Private equity investment is a long-term commitment with unique fund dynamics

One crucial aspect to be particularly mindful of is the long time horizon of these investments. The repayment period for a private equity investment typically spans 8-10 years but can extend up to 12-15 years.

This can be illustrated by the so-called J-Curve (see graphic below), illustrating the fund's value across the four phases of its lifecycle.

In this curve, the fund only reaches liquidity equilibrium in the last phase of the life cycle – when companies are successfully sold with profit. Only then will you, as an investor, realize gains from your investment.

It's crucial to evaluate whether this long repayment period aligns with your investment time horizon, given the binding nature of your commitment. Because while there are cases where one can withdraw from a commitment, it usually happens under very unfavorable conditions.

2. You must be able to meet capital calls promptly

Your commitment to a private equity fund is binding, and when the fund calls a portion of your committed capital, you must be able to meet it promptly.

Though highly unlikely, should all the funds you've invested in call for your unfunded commitment at the same time, you must be able to meet all of their capital calls. Ensuring total liquidity readiness at all times is therefore of the essence when investing in private equity.

Importantly, financial crisis situations that can make it challenging to realize other assets are no exception.

Ensuring total liquidity readiness at all times is of the essence when investing in private equity.

3. There are high costs associated with private equity investment

Compared to investing in stocks and bonds, private equity funds entail relatively high costs. In addition to operating expenses, there's the General Partner's performance fee – known as their carried interest – which they receive when the fund's returns exceed the specified hurdle rate.

4. Private equity investments are less transparent than traditional investments

Investments in private equity are less transparent compared to traditional asset classes like stocks and bonds. As mentioned, the private equity market lacks the same level of regulation as the publicly traded market, where stringent reporting requirements dictate when and how publicly traded companies should report and disclose information.

As a result, there are no rules or common standards telling funds how to report on their investments. It largely depends on each fund to decide how they report and calculate various private equity metrics. This is essential to keep in mind when comparing different private equity investments. Read more about this issue in our article on creating a comprehensive private equity overview.

At Aleta, we are highly experienced within private equity reporting. We apply consistent calculation methods across all funds, ensuring you have an accurate overview of your private equity investments.

It largely depends on each fund to decide how they report and calculate various private equity metrics.

5 decisions to make before investing in private equity

1. Does a private equity investment complement your portfolio?

When considering investing in private equity, it's crucial you assess whether such an investment complements the rest of your portfolio. Does it align with your investment strategy and risk profile?

2. What type of private equity fund do you want to invest in?

Various types of private equity funds exist, each with different strategies and risk levels. Capital funds and venture funds are two of the most popular types. The maturity and establishment of the companies they invest in can vary from fund to fund.

In general, the newer and less established a company is, the higher the risk associated with investing in it. You have to determine the level of risk you are willing to take and choose a fund type that aligns with your risk profile.

3. Do you want a specific sector tilt in your private equity investments?

Private equity funds often focus on investing in companies with common characteristics, such as a specific industry or geographic region. Consider whether there's a particular sector you'd like to invest in and choose private equity funds that align with your preferences.

4. How do you want to invest in private equity?

This might sound like an odd question, but there are, in fact, several ways to invest in private equity. Keep in mind that the investment approach you choose can involve different layers of costs.

Consider whether you want to invest directly in a private equity fund to minimize costs or if another method suits your situation and investment strategy better.

5. Do you have specific requirements for a side letter?

"Now, what is a side letter," you may ask.

When investing in a private equity fund, many investors have a side letter drawn up with specific requirements that the fund must commit to before entering a Limited Partner Agreement.

This could include specifying rights for a potential resale of commitment, receiving notifications if another investor misses a capital call, or establishing ethical frameworks.

In the context of side letters, the concept of most favored nation (MFN) is often used. If your side letter includes an MFN agreement with the fund, it means that if new investors join the fund later and negotiate better terms – for example, regarding costs – you, as an MFN, have the right to obtain the same terms.

However, this often applies only to investors with a similar commitment size and depends on when the new investors enter the fund. Achieving an MFN clause usually involves some negotiation.

If your side letter includes an MFN agreement with the fund, it means that if new investors join the fund later and negotiate better terms – for example, regarding costs – you, as an MFN, have the right to obtain the same terms.

We've now gone through a number of considerations you have to make before investing in private equity. Once you've invested, it's essential to continually evaluate your private equity investments, not to mention keeping a correct overview of your total unfunded commitments.

Let me know if we can be of any help with regards to your private equity reporting or if you have any questions for this article.

Keep an eye out for our next piece on private equity.

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